2 Laggards to Crumble Beneath the 3-Headed Cloud Monster

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Rackspace Hosting shares soared nearly 8% on Tuesday after reporting better-than-expected earnings. The web-hosting and cloud services company has seen its valuation decline 25% this year, and many believe this quarter may serve as a reversal of bad fortunes. Unfortunately, Rackspace -- as well as Salesfoce.com -- has a three-headed monster in its way, which includes juggernauts Amazon , Microsoft , and IBM .

3 companies that are taking cloud by storm
Amazon, Microsoft, and IBM are the three leaders in the cloud and are growing at a rate that exceeds the overall industry. In the last two quarters, cloud infrastructure, or laaS, and app platforms, or PaaS, grew at a rate of 51%, yet the big three have outpaced this growth by a significant margin.


Fourth Quarter 2013 Annual Growth

First Quarter 2014 Annual Growth










Combined, these three companies command about 45% of the total market share -- Amazon owns more than 30%. With that share rising, it means that smaller players are losing share, which consequently could mean a decline in valuation. Essentially, this is a highly valuable business, growing fast, and is important to most of the big technology companies.

Rackspace's decision will become costly
In Rackspace's strong quarter, it grew revenue by 16.2%, to $421 million, while $121.4 million, or 28.8%, was created from its cloud business. That represented year-over-year growth of 34%. Essentially, the cloud is Rackspace's growth engine, but this segment is underperforming the rate of growth for the laaS/PaaS industry. Therefore, Rackspace is losing market share to the big three within this space.

With that said, investors are praising Rackspace for a job well-done, while forgetting that in April the company expressed its belief that it offers premium products and will not price services based on the actions of its competitors. This came after Microsoft cut prices for its cloud offerings by 27%-35%,  and Amazon then followed suit, cutting the majority of its top services by 30%, marking the 42nd cut in AWS's history.

Most of Rackspace's stock decline this year has been in connection to the large investments made by tech companies in the cloud -- and uber-competitive pricing. Specifically, Rackspace claims it provides premium products, but its $0.68-per-hour cost for a 15GB cloud server with SSD storage is significantly higher than Amazon's $0.28-per-hour charge for the same product. With that said, we could go down the line of Rackspace's products, compare them to cloud competitors, and have similar findings of disconnected prices.

Rackspace is not alone
Rackspace is not alone in its struggles, although it does seem the most oblivious to the growing three-headed threat. Salesfoce.com is a company that relies heavily on this space to create growth, and it is struggling to keep its head above water. Salesforce.com once dominated part of this industry, holding a market-best 18% share of the PaaS segment with its Heroku cloud app platform during the third quarter of 2013. However, its year-over-year growth has been below the industry average, growing just 37% in the first quarter, and now ranking fourth behind Amazon, Microsoft, and IBM, respectively.

Salesforce.com has at least tried to find answers to this problem, most notably by trying to unify its popular Heroku and Force.com platforms. But, at eight times sales, Salesforce.com is not valued much less than AWS's 12.5 times sales; AWS has a $50 billion valuation and produces more than $1 billion per quarter. With slowing growth, a falling market share, and a rich premium, investors might be best served avoiding the Salesforce.com as a play on the cloud.

Final thoughts
Rackspace's first three months of 2014 were decent, but investors should keep in mind that industrywide price cuts didn't occur until late March and early April. Therefore, we are yet to see how Rackspace compares against these prices.

Moreover, Rackspace is small relative to the big three, and its service offerings aren't as broad. Therefore, it seems logical that Rackspace would be losing market share, and if not for the sheer growth of the entire industry, Rackspace's earnings wouldn't look so appealing.

Pricing is even more competitive, the services are near equal, and with a smaller product offering, it seems unrealistic to think that Rackspace can stand the test of time. Ultimately, this means that Rackspace's days of stock losses might not be over, and along with Salesforce.com, its market-share growth rates over the last six months serve as great proof.

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The article 2 Laggards to Crumble Beneath the 3-Headed Cloud Monster originally appeared on Fool.com.

Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Rackspace Hosting, and Salesforce.com. The Motley Fool owns shares of Amazon.com, International Business Machines, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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